Don’t Assume a Fed Action Will Move the Market

Robert J. ShillerDecember 07, 2015

Following a positive jobs report, the Fed is widely expected to raise interest rates when it meets later this month. In the New York Times, Yale SOM's Robert Shiller writes that our responses to such an event are unpredictable, even when we know in advance that it will happen.

Humans don’t behave like computers. That makes life interesting, but it has a serious downside for economists: It is exceedingly difficult to predict the short-term directions of major markets, even when events seem to be entirely predictable.

The forthcoming decision of the Federal Reserve on interest rates is a humbling example. Consider that after seven years of virtually zero percent short-term interest rates, the Federal Open Market Committee is almost universally expected to raise rates slightly at its December 15–16 meeting.

What this means for the markets isn’t clear, however. We can’t rely on historical precedent. The last time rates rose after remaining very low for so long was in 1941. That was a long time ago, and when there has been only one previous example, in very different circumstances, historical statistics won’t prove much of anything.

There are other ways of analyzing the likely effects of the Fed actions, but all have severe limitations.

First, logic tells us that if short-term Treasury rates rise, low-risk Treasury bills may become more attractive in comparison with riskier alternatives like stocks. That suggests that the stock market should weaken because people will become even more wary than they may be right now about share prices, which have tripled since 2009. Home prices should weaken too, because rising interest rates can be expected to make mortgages more expensive. In other words, this line of thinking is quite negative about the general effect of a rate increase on market prices.

There is another way to look at this, though. If the Fed raises rates in December it could be seen as good news because the Fed wouldn’t take that action unless it viewed the economy as relatively strong. That could buoy market prices.

This approach immediately leads to further complications. Good news about the economy might be bad news about inflation, which tends to rise when economic growth picks up. On the other hand, if inflation rises, even if the Fed raises rates slightly, the real, or inflation-corrected, interest rate might actually be lower, not higher. Confused? That is understandable: This line of thinking might lead us into a muddle very quickly. But don’t be surprised if you hear circuitous commentary like this in the weeks ahead.

Then again, the prevailing wisdom might be reflected in yet another common argument, which may be summarized in one word: boring. The markets already know everything there is to know about rates, or so this line of thinking goes, and because a rate increase is expected it should already be “discounted into” current share prices. This is a very simple version of the efficient markets theory, which holds that all available information is already fully reflected in market prices, so only true surprises really matter.

It could be argued that the Fed will surprise people only if it doesn’t raise rates after Friday’s strong jobs report, or raises them less than expected or issues a statement that is weaker than expected. Something like that may have happened on Thursday when the European Central Bank’s stimulus measures evidently disappointed the markets.

But a major surprise from the Fed? That would be surprising.

All of which is to say that we don’t know what will happen if and when the Fed raises rates. And the problem becomes much more complicated when you include human psychology in your economic analysis, as we try to do in the emerging field of behavioral finance. In fact, from a psychological perspective, the whole efficient markets idea that only real surprises matter and there should be no reaction to “news” that is well known in advance is a little off base. People often don’t know in advance how they will react until news becomes real.

The psychologists Eldar Shafir and Amos Tversky in 1992 called this phenomenon nonconsequentialist reasoning, by which they meant that we often just can’t discipline ourselves to think through the likely consequences of possible events, so instead just let ourselves be buffeted by news as it happens. This suggests that an interest rate rise might not be boring at all: We will have to wait and see.

After all, with rates this low, some people may have been engaging in behavior that isn’t entirely rational and that has a basis in well-documented wishful-thinking bias. As Janet Yellen, the Fed’s chairwoman, said in her Semiannual Monetary Policy Report to the Congress last July: “The committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events.”

Reaching for yield—taking actions without fully considering risk, to try to earn greater returns than are found in traditional safe investments—may be a form of wishful thinking known as exaggerated expectation, which has been studied in many areas of life. For example, the psychologist Elisha Babad showed that sports fans often have exaggerated expectations for their teams, much as voters exaggerate the probability that their preferred candidate will win.

In the near zero-interest-rate environment of recent years, people have naturally searched for alternative investments, and that may have led them into wishful thinking. People might be viewing high prices in the stock and housing markets as evidence of the inherent worth of these assets, disregarding the role that low interest rates have played in bolstering those prices. Some people have undoubtedly taken personal pleasure in their investing success, interpreting it as proof of their own self-worth. Identity and ego may be an issue, and that can be very dangerous.

People may have strong reactions when their identity is connected to things that turn out to be disappointing, after the initial reason for their excitement is gone. After the financial crisis in 2008, for example, many highfliers found that their identities as smart stock pickers or home buyers were severely challenged. It could happen again. But I’m afraid we will just have to wait and see.